Tutor Marked Assignment
Question 1(a)
The set-up in this problem is a tourist-dependent economy heavily relying on the air travel industry for its proper functioning. Some of the prominent examples of such real-life economies, particularly in Asia include; Malaysia, Thailand, Singapore, and Vietnam. We consider two simultaneous events that can affect the air travel market and, consequently, help grow or de-accelerate our tourist-based economy.
Event 1: Economy runs into recession, and unemployment increases significantly
Event 1 describes our economy to be hit by a recession, which consequently results in massive layoffs and unemployment rates. One crucial fact to note in our analysis is that air travel for tourism is a luxury good, at least for most individuals. This means that the decrease in demand is proportionally greater than the reduction in income. So, when consumers lose their job due to unemployment and recession, their income decreases and they are left with their savings or other assets to survive. Naturally, they would want to use the money to purchase necessities such as food, medicines, housing, etc. All luxuries would be put aside for the time being. Thus, we observe the decrease in market demand for air travel in the rise of event 1. Also, the air travel industry is elastic (for leisure travelers). This is because if one airline’s price increases, consumers can easily switch to other options due to the wide range of substitutes available. Hence, market demand is relatively flat.
Consider the market for the air travel industry where the downward sloping D0 represents the initial demand and upward sloping S0 represents the initial supply. The intersection of market demand and supply gives the equilibrium price P0 and equilibrium quantity Q0. After the recession and an increase in unemployment, we observe a drop in the market demand for air travel. Consequently, the demand curve shifts to left and we get D1 as the new market demand.
The intersection of D1 and S0 gives new equilibrium. Thus equilibrium price, as well as equilibrium quantity both, decrease post-recession.
Event 2: Strike by pilots post discussion collapse between pilot unions and management
Failure to reach an agreement between pilot unions and airline management can result in several pilots organizing strikes and refusing to work. It will result in a lesser number of workers available for the job-at-hand in the air travel market. Consequently, the market would observe the reduced supply of airline services in the wake of pilot increases. Graphically, the supply curve shift towards the left to capture the decrease in market supply. Hence, we get the new market supply as S1. The intersection of D0 and S1 gives a new equilibrium. Accordingly, equilibrium price increases due to pilot strikes, whereas equilibrium quantity decreases.
To get the complete market picture due to the above concurrent effects, we consider both demand reduction and supply reduction in the same diagram. The intersection of D1 and S1 gives the new equilibrium price and equilibrium quantity. As one can expect by the above graphs, the equilibrium quantity certainly decreases (and becomes Q1) since both market demand and market supply decrease in the rise of the above two events. However, the equilibrium price demonstrates opposite patterns under both events. Equilibrium price decreases under event 1 while it increases under event 2. So, the overall equilibrium price may either decrease, increase, or remain unaffected depending upon the relative decrease in market demand and market supply if the decrease in demand is greater than the reduction in supply, equilibrium price decreases whereas when the decrease in demand is less than the decline in supply than equilibrium price increases. Equilibrium price remains unchanged when the decrease in supply completely offsets the decrease in demand. The following three graphs show this.
Given the concurrent events in question, it seems that economic recession and unemployment would create a greater impact than the temporary pilot strikes since the former is long-lasting. So the first scenario seems most likely where demand decreases greater than the decrease in supply. Accordingly, equilibrium quantity and equilibrium prices are both expected to decrease.
Question 1(b)
Price elasticity of demand measures how responsive or sensitive is the demand for a particular good with respect to change in its price. Several factors determine the price elasticity of demand. The most common ones are – availability of substitutes, time frame, percentage of income spent, and nature of the good (luxury v/s necessity). As already mentioned in part (a), demand for a particular airline in the airline industry is elastic due to a plethora of alternative substitutes owing to the competition between airlines. Also, depending upon the type of travel, the nature of this good is defined. So we can analyze price elasticity of demand considering both kinds of travelers – business travelers and leisure travelers.
- Business travelers
A business traveler might need to travel to different places to meet clients, finalize business deals, etc. Traveling may be an essential part of their job and such plans may usually be conveyed to the employee at very short notice. Accordingly, air travel can be a necessity good for business travelers and not something they are doing for their pleasure. Thus, airline price fluctuations would have little to no impact on the demand for air travel by business travelers, and the airline industry is relatively inelastic. Also, as an additional factor, the worker’s income plays a minimal role in this decision since the respective employers usually sponsor travel tickets for work. Accordingly, the purchasing power of an individual business traveler remains unaffected by an increase in airline prices. A possible graph for such an inelastic market is given by the steep slope of the market demand, as shown in the figure below:
- Leisure travelers
For a leisure traveler, air travel (or tourism) is a luxury good. It is something that is not necessary for the daily smooth functioning of the life of a leisure traveler and can be postponed to a later date. Accordingly, if prices increase suddenly, there might be a dip in the flight bookings by leisure travelers since they may want not to travel immediately or prefer other modes of transport over air travel. On the other hand, a sudden decrease in airline prices may boost the market demand for leisure travelers who want to make most of the cheap flights available for recreational purposes. Both examples point that demand for air travel is highly sensitive for leisure travelers and thus is elastic. The above graph shows the relatively flat demand curve in this scenario.
Question 1(c)
Income elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in income of the consumer. If an increase in consumer income increases the demand for a good, it is known as a normal good. Thus, the income elasticity of demand is positive for such goods. The airline industry is a normal good. Normal goods can further be categorized as:
- Necessity goods (0 < IED < 1)
- Luxury goods (IED > 1)
Alternatively, if an increase in consumer income decreases the demand for a good, it is also known as an inferior good. IED is negative for inferior products.
Now, if we assume a large decrease in travelers’ income, the quantity demanded air travel should decrease. It is because it is a normal good. But how much would it decrease would depend on the type of traveler and the nature of good for him/her. This is also inherently related to the concept of price elasticity of demand.
Consider first the case of business travelers. As mentioned in part (b), air travel is a necessity good for business travelers. (And also, likely, the individual’s income is not used to purchase the ticket for business purposes). A large decrease in the income of business travelers implies a huge decrease in their purchasing power. This can be equivalently considered as the large increase in the price of the air tickets due to the income effect. But since the demand for air travel for business travelers is relatively inelastic, the quantity demanded shouldn’t change. Accordingly, total revenue for the airlines, given by price times quantity sold, doesn’t adjust much for the business travelers.
For leisure travelers, we have mentioned that air travel is considered a luxury good. Thus, a significant decrease in consumers’ income would decrease the demand for air travel by larger proportions. Considering the prices of airlines to be constant, a reduction in the quantity demanded will reduce the revenue generated for the airlines.
Mathematically, the relationship between total revenues and price elasticity of demand is given as:
For business travelers, demand is relatively inelastic. However, the change in quantity demanded is approximately zero. Hence total revenue doesn’t change for business travelers.
For leisure travelers though, demand is highly elastic. So, PED is very large. For the extreme case where demand is perfectly elastic, PED is infinite. This implies:
And hence the entire change in quantity demanded due to the decrease in consumer income would translate to the decrease in the revenue of airlines.
This result can also be derived using the definition of income elasticity of demand –
For a necessity good (air travel for business travelers), IED is between 0 and 1. Thus a large decrease in consumer income would only result in a small decrease in the quantity of air travel demanded. Hence, assuming the price of airlines to be constant, total revenue only decreases by a small amount for the case of business travelers.
For a luxury good (air travel for leisure travelers), IED is larger than 1. So, a large decrease in consumer income is met with an even larger decrease in the quantity demanded. As a result, total revenue decreases by a huge amount for the case of leisure travelers.Graphically, change in total revenues versus price elasticity of demand can be plotted as:
References
National Bureau of Economics Research. (n.d.). The NBER’s Business Cycle Dating Procedure.
http://www.nber.org/cycles/recessions.html.
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